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Business Week cover story Sept. 2006: Nightmare Mortgages

Because banks don't have to report how many option ARMs they underwrite, few choose to do so.

So how did these unusual loans get into the hands of so many ordinary folks? The sequence of events was orderly and even rational, at least within a flawed system. In the early years of the housing boom, falling interest rates made safe fixed-rate loans attractive to borrowers. As home prices soared, banks pushed adjustable-rate loans with lower initial payments. When those got too pricey, banks hawked loans that required only interest payments for the first few years. And then they flogged option ARMs -- not as financial-planning tools for the wealthy but as affordability tools for the masses. Banks tapped an army of unregulated mortgage brokers to do what needed to be done to keep the money flowing, even if it meant putting dangerous loans in the hands of people who couldn't handle or didn't understand the risk. And Wall Street greased the skids by taking on much of the new risk banks were creating.

Now the signs of excess are crystal clear. Up to 80% of all option ARM borrowers make only the minimum payment each month, according to Fitch Ratings. The rest of the money gets added to the balance of the mortgage, a situation known as negative amortization. And once balances grow to a certain amount, the loans automatically reset at far higher payments. Most of these borrowers aren't paying down their loans; they're underpaying them up.

Yet the banking system has insulated itself reasonably well from the thousands of personal catastrophes to come. For one thing, banks can sell some of their option ARMs off to Wall Street, where they're packaged with other, better loans and re-sold in chunks to investors. Some $182 billion of the option ARMs written in 2004 and 2005 and an additional $83 billion this year have been sold, repackaged, rated by debt-rating agencies, and marketed to investors as mortgage-backed securities, says Bear, Stearns & Co. (BSC )Banks also sell an unknown amount of them directly to hedge funds and other big investors with appetites for risk.

The rest of the option ARMs remain on lenders' books, where for now they're generating huge phantom profits for some lenders. That's because, according to generally accepted accounting principles, or GAAP, banks can count as revenue the highest amount of an option ARM payment -- the so-called fully amortized amount -- even when borrowers make only the minimum payment. In other words, banks can claim future revenue now, inflating earnings per share.

For many industries, so-called accrual accounting, which lets companies book sales when they contract for them rather than when they receive the cash, makes sense. The revenues will eventually come. But accrual accounting doesn't apply well to option ARMs, since it's more difficult to know if unpaid interest will ever cross a banker's desk. "This is basically an IOU that may never get paid," says Robert Lacoursiere, an analyst at Banc of America Securities. James Grant of Grant's Interest Rate Observer recently wrote that negative-amortization accounting is "frankly a fraudulent gambit. But what it lacks in morality, it compensates for in ingenuity." The Financial Accounting Standards Board, which is responsible for keeping GAAP up to date, stands by its standard but told BusinessWeek in a written statement that it is "concerned that the disclosures associated with these types of loans [are] not providing enough transparency relative to their associated risks."

Why are hedge funds willing to buy risky loans directly? Because they can demand terms that help insulate them from losses. And banks, knowing what the hedge funds want in advance, simply take it out of the hides of borrowers, many of whom qualify for lower rates based on their credit histories. "Even if the loan goes bad, [the hedge funds are] still making money hand over fist," says Engel.

Eventually, some of it will go sour. But the Wall Street pros who buy option ARMs are in the business of managing risk, and no one expects widespread losses. They've taken on billons in iffy option ARMs, but the loans are no shakier than the billions in emerging market debt or derivatives they buy and sell all the time. Blowups are factored into the investing decision.

Banks that hold lots of option ARMs on their books will surely be hit by loan defaults in coming years. "It's certainly reasonable to expect to see some excesses wrung out," says Brad A. Morrice, president and CEO of New Century Financial Corp. But even here the damage will likely be limited. Banks use insurance and other financial instruments to protect their portfolios, and they hold real assets -- homes -- as collateral. Christopher L. Cagan, director of research and analytics at First American Real Estate Solutions, a researcher and unit of title insurer First American, forecasts total defaults of $300 billion across all types of loans, not just option ARMs, over the next five years -- less than 1% of total homeowner equity. (In comparison, JPMorgan Chase & Co. alone has a mortgage portfolio of $182.8 billion.) Cagan estimates that banks will end up losing only $100 billion of it all told.

Most of the pain will be born by ordinary people. And it's already happening...

Note that even while the editors found the "excesses crystal clear" they all still agreed the damage among the financial institutions would be contained.

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